Note 2. Fair Value of Financial Instruments

6 Months Ended

Jun. 30, 2012

Fair Value Disclosures [Text Block]

NOTE 2 – FAIR VALUE OF FINANCIAL INSTRUMENTS

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.  There are three levels of inputs that may be used to measure fair values:

Level 1:  Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity can access as of the measurement date.

Level 2:  Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3:  Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The following is a description of the Company’s valuation methodologies used to measure and disclose the fair values of its financial assets on a recurring or nonrecurring basis:

Securities:  The fair values for securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations.

Impaired Loans: At the time a loan is considered impaired, it is valued at the lower of cost or fair value.  Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses.  For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.  Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification.  Impaired loans are evaluated on a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis.  These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company.  Once received, a member of management reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with management’s own assumptions of fair value based on factors that include recent market data or industry-wide statistics.  On an as-needed basis, the Company reviews the fair value of collateral, taking into consideration current market data, as well as all selling costs that are typically in the range of 10%.

Mortgage Servicing Rights: On a quarterly basis, loan servicing rights are evaluated for impairment based upon the fair value of the rights as compared to carrying amount.  If the carrying amount of an individual tranche exceeds fair value, impairment is recorded on that tranche so that the servicing asset is carried at fair value.  Fair value is determined at a tranche level, based on discounted cash flows (Level 3).

Assets Measured on a Recurring Basis

Assets measured at fair value on a recurring basis are summarized below:

	Fair Value Measurements at June 30, 2012, Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable  Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
U.S. Treasury securities		----	$	1,501		----
U.S. Government sponsored entity securities		----		1,005		----
Agency mortgage-backed securities, residential		----		91,253		----

	Fair Value Measurements at December 31, 2011, Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable  Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
U.S. Treasury securities		----	$	5,513		----
U.S. Government sponsored entity securities		----		2,559		----
Agency mortgage-backed securities, residential		----		77,598		----

There were no transfers between Level 1 and Level 2 during 2012 or 2011.

Assets Measured on a Nonrecurring Basis

Assets measured at fair value on a nonrecurring basis are summarized below:

	Fair Value Measurements at June 30, 2012, Using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets:
Impaired Loans:
Commercial real estate:
Owner-occupied		----		----	$	2,407
Nonowner-occupied		----		----		409
Mortgage servicing rights		----		----		417

	Fair Value Measurements at December 31, 2011, Using
Assets:	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired Loans:
Commercial real estate:
Owner-occupied		----		----	$	290
Nonowner-occupied		----		----		1,959
Construction		----		----		587
Mortgage servicing rights		----		----		430
Other real estate owned:
Commercial real estate:
Construction		----		----		1,814
Commercial and industrial		----		----		1,134

The portion of impaired loans at June 30, 2012 with specific allocations of the allowance for loan losses had a carrying amount of $4,661 and was measured for impairment using the income and comparable sales approach.  This measurement resulted in a valuation allowance of $1,845 at June 30, 2012, which contributed to an increase of $1,946 in provision for loan loss expense during the six months ended June 30, 2012. This increase was larger than the increase of $1,306 in provision for loan loss expense from impaired loans during the six months ended June 30, 2011. The portion of impaired loans at December 31, 2011 with specific allocations of the allowance for loan losses had a carrying amount of $3,491. The loans were measured for impairment using the income approach. This measurement resulted in a valuation allowance of $655 at December 31, 2011.

During the six months ended June 30, 2012, there was no change in valuation adjustments recorded on mortgage servicing rights measured at fair value.  Mortgage servicing rights, which are carried at lower of cost or fair value, were carried at their fair value of $417, which is made up of the outstanding balance of $560, net of a valuation allowance of $143 at June 30, 2012. This fair value is slightly less than the fair value of $430 at December 31, 2011, made up of the outstanding balance of $573, net of a valuation allowance of $143.  This decrease in mortgage servicing rights from December 31, 2011 to June 30, 2012 is largely due to amortization that is recorded in proportion to and over the period of the mortgage servicing rights’ estimated future servicing income of the underlying loans.

During the six months ended June 30, 2012, there was no other real estate owned measured at fair value less costs to sell.  Other real estate owned that was measured at fair value less costs to sell at December 31, 2011 had a net carrying amount of $2,948, which was made up of the outstanding balance of $4,214, net of a valuation allowance of $1,266, which resulted in a corresponding write-down of $1,266 for the year ended December 31, 2011.

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at June 30, 2012:

	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range		(Weighted Average)
Impaired Loans:
Commercial real estate:
Owner-occupied	$	2,152	Income approach	Adjustment for differences between the comparable sales	from -10% to     -20%			-18%
			Income approach	Capitalization rate	from 7% to    10%
Owner-occupied		255	Income approach	Capitalization rate		10%
Nonowner-occupied		409	Income approach	Capitalization rate		10%

The carrying amounts and estimated fair values of financial instruments at June 30, 2012 and December 31, 2011 are as follows:

Fair Value Measurements at June 30, 2012 Using:

	Carrying Value		Level 1		Level 2		Level 3		Total
Financial Assets:
Cash and cash equivalents	$	73,723	$	73,723	$	----	$	----	$	73,723
Securities available for sale		93,758		----		93,758		----		93,758
Securities held to maturity		24,269		----		11,917		12,898		24,815
Federal Home Loan Bank stock		6,281		N/A		N/A		N/A		N/A
Loans		564,074		----		----		581,056		581,056
Accrued interest receivable		2,371		----		554		1,817		2,371
Financial liabilities:
Deposits		683,179		142,421		543,059		----		685,480
Other borrowed funds		20,089		----		20,574		----		20,574
Subordinated debentures		13,500		----		10,304		----		10,304
Accrued interest payable		1,721		----		1,721		----		1,721

	December 31, 2011
	Carrying Value		Fair Value
Financial Assets:
Cash and cash equivalents	$	51,630	$	51,630
Securities available for sale		85,670		85,670
Securities held to maturity		22,848		22,847
Federal Home Loan Bank stock		6,281		N/A
Loans		590,964		599,782
Accrued interest receivable		2,872		2,872
Financial liabilities:
Deposits		687,886		690,607
Other borrowed funds		20,296		20,565
Subordinated debentures		13,500		11,085
Accrued interest payable		1,894		1,894

The methods and assumptions, not previously presented, used to estimate fair values are described as follows:

Cash and Cash Equivalents: The carrying amounts of cash and short-term instruments approximate fair values and are classified as Level 1.

Federal Home Loan Bank stock: It is not practical to determine the fair value of Federal Home Loan Bank stock due to restrictions placed on its transferability.

Securities Held to Maturity:  The fair values for securities held to maturity are determined in the same manner as securities held for sale and discussed earlier in this note.  Level 3 securities consist of nonrated municipal bonds and tax credit (“QZAB”) bonds.

Loans: Fair values of loans are estimated as follows:  The fair value of fixed rate loans is estimated by discounting future cash flows using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification.  For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification.  Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

Deposit Liabilities: The fair values disclosed for noninterest-bearing deposits are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 1 classification.The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date resulting in a Level 2 classification. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

Other Borrowed Funds: The carrying values of the Company’s short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification. The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

Subordinated Debentures: The fair values of the Company’s Subordinated Debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

Accrued Interest Receivable and Payable: The carrying amounts of accrued interest approximate fair value resulting in a Level 2 or Level 3 classification.

Off-balance Sheet Instruments:  Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.

In addition, other assets and liabilities that are not defined as financial instruments were not included in the disclosures below, such as premises and equipment and life insurance contracts.

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.